In an earlier article, we had spoken about 5 Ratios That Show Your Business’s Health. In the present article, we will discuss the important profitability ratios which you should calculate at regular intervals in order to be on top of your business finances. Investopedia defines Profitability Ratios as, “A class of financial metrics that are used to assess a business’ ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. For most of these ratios, having a higher value relative to a competitor’s ratio or the same ratio from a previous period is indicative that the company is doing well.”
Profitability Ratios Help In:
- Gauging business performance
- Making business decisions related to expansion or diversification
- Enabling lenders/investors to attain a clear picture of the business and access additional resources
The important profitability ratios are:
- Gross-Profit ratio shows how efficiently your company utilizes its resources, materials, and labor to generate profit. Additionally, the gross profit ration helps measure your business’ manufacturing and distribution efficiency during the production process.
- Gross-Profit ratio is calculated as gross profit divided by total sales (revenue)
- A higher Gross-Profit ratio indicates that the business is cost-effective.Note that investors use the gross-profit ratio to compare the profitability of business’s in the same industry and also in different industries.
- Net-profit ratio is a key profitability ratio that shows the amount of rupees left over from each sale after all expenses have been paid.
- Net Profit = Profit (after tax) / Revenue
- A higher net profit ratio means that your business is more efficient at converting sales into actual profit
Operating Ratio or EBIT (Earnings Before Interest and Taxes):
- EBIT measures a firm’s profits including all expenses except interest and income tax
- It represents your business’s earning power from on-going operations
- EBIT = Revenue – Operating Expenses or EBIT = Net Income + Interest + Taxes
Cash Flow Margin Ratio:
- Cash-Flow Margin ratio is a key profitability ratio that gives insight into your company’s inner workings
- It measures how well the business’s operations are creating cash from sales
- Cash flow margin = Cash flows from operating activities / Net sales
- A high cash flow margin indicates efficiency at debts collection and also a high earnings quality